When Saudi Arabia Says ‘Jump!’ OPEC Responds ‘How High?’

OPEC is in fighting form these days.

Since the disastrous Saudi-Russia price war was called off after five weeks, the cartel has not only righted its own ship, defying yet another round of commentary about its demise, but seems to have fixed global oil markets in the midst of an unprecedented demand collapse – just in time for OPEC’s 60^th birthday.

Once recalcitrant OPEC members have suddenly found religion. Not only are they not cheating on quotas, but they are over-complying for good measure, or promising to do so. Led by Saudi Arabia and its Gulf allies producing a million barrels per day less than their quotas, compliance by the two dozen OPEC+ countries with the 9.7mbd in pledged cuts was reportedly 108% in June.

Moscow and Riyadh are back in lock step. Oil prices have gotten a big kick in the pants. The OPEC basket reached $43/bbl on Friday. It’s almost as if Saudi Arabia says, “Jump!” and the rest of OPEC+ responds, “How high?”

How did we get here? President Trump played a useful role in getting the Saudis to climb down from the April price war that coincided with oil demand-ravaging coronavirus.

Since then, developments point to a more ruthless, more efficient cartel leadership. The fingerprints of Saudi Crown Prince Mohammed bin Salman, the “young man in a hurry” are evident, as are those of his half-brother, the new oil minister Prince Abdulaziz, the so-called “technocratic royal,” who is proving plenty tough. This is not the cautious Saudi leadership we grew up with.

No More Mr. Nice Guy

In the past, Saudi Arabia would wait for data to come in on cheating, then slowly escalate the pressure moving from quiet diplomacy to public shaming, threats, and with a price war as the last resort.  Not now. Before the June production figures had even come in, Prince Abdulaziz skipped the usual niceties and went straight to threatening another all-out price war.

Moreover, Prince Abdulaziz has told quota cheats to pay “compensation” for lack of prior adherence. This means they must take offline 1.25 million barrels per day that they neglected to cut in prior months.

“We have no room whatsoever for lack of conformity,” Prince Abdulaziz said. Lo and behold, it’s worked.

The Saudis have forced Angola, Nigeria and Iraq to commit to not only to obeying their quotas, but to enhanced cuts compensating for prior cheating. Angola was overproducing by 90,000 barrels a day in May, Nigeria by 175,000, and Iraq by a massive 600,000 b/d. Russia has pushed Kazakhstan, which was overproducing by 125,000 b/d, into the same agreement.

Carrots, Sticks and Recklessness

Riyadh is employing carrots as well as sticks. Saudi Arabia’s hardball with Baghdad contrasts with its appointment of a new ambassador and commercial attaché at its newly reopened embassy – it’d been shuttered for 25 years – along with a slew of loan and investment promises, including bankrolling development of the Okaz gas field.

It’s less clear whether there’s a carrot involved with Angola’s and Nigeria’s change of heart. There was certainly a stick:  Prince Abdulaziz recently warned both countries’ OPEC delegations, “We know who your customers are.”  At the outset of July, Angola refused not only to make compensatory cuts, but also to stop cheating. A few days later, Luanda is on board with the entire package.  The Saudi crown prince called Nigerian President Buhari in late June, and Abuja has pledged full compliance this month.

Angola and Nigeria may simply have been impressed by Saudi recklessness on display in April, when it launched a spur-of-the-moment price war. The kingdom backed up its threat with a huge boost in production, reaching an unheard of 12 million b/d just as the coronavirus was pushing world oil demand into free-fall. Every oil producer on the planet was aghast, not just OPEC laggards. Such impulsiveness may be the nail-studded stick backing up Prince Abdulaziz’s compensation demands.

Climate Change Bolsters Quota Enforcement

The bigger picture makes cheating even less appealing. Oil producers with which Saudi Arabia disagrees have a tendency to stumble. Witness once headstrong Libya. Libya only managed to eke out 90,000 b/d in May amid civil war, just five percent of the 1.8 million b/d it produced in 2010, after Saudi Arabia, Abu Dhabi and Russia began supporting Libyan rebels led by Khalifa Haftar.

Saudi OPEC rivals Venezuela and Iran have been taken almost entirely offline with equally disastrous results. Those outages are based on US sanctions, compounded in Venezuela’s case by internal mismanagement. Qatar has quit the bloc entirely.

Direct intervention has the dual purpose of not only punishing recalcitrant regimes, but rewarding allies with a piece of the offender’s market share. Look for OPEC to get even tougher as climate action begins to eat away at oil demand and quota enforcement gets even more critical.

OPEC’s near-term success in market management faces numerous roadblocks, including – if prices continue to rise – the revival of US shale production. The current OPEC+ cuts are noteworthy. They started in 2017. Aside from the short hiatus in April, the cuts could be in place all the way into 2022, with managed reductions along the way as oil demand recovers from virus-induced travel restrictions.

Like every cartel, the OPEC/OPEC+ group has historically struggled with enforcement and free riders.  For Riyadh, the benefits of better discipline are obvious.  Higher oil prices are desperately needed to fund Crown Prince Mohammed’s vision of modernizing the Kingdom, while better discipline by the laggards shares the pain within OPEC, so Saudi Arabia doesn’t sacrifice alone.

Has Saudi Arabia finally found the “secret sauce?”  Or will today’s discipline – driven by the biggest-ever plunge in oil demand – fade alongside the virus? Too early to say. But Saudi Arabia’s newfound willingness to act must have OPEC slackers thinking twice about cheating.

At the end of the day, though, too much price warfare undermines OPEC’s overall mission of greater predictability and lower market volatility.  In oil markets, a little “crazy” goes a long way.

This post originally appeared in the Forbes Blog on July 13, 2020.